Chapter 05 Ans

Chapter 05 - Introduction to Risk, Return, and the Historical Record
Chapter 05 Introduction to Risk, Return, and the Historical Record Answer Key

Multiple Choice Questions

1. Over the past year you earned a nominal rate of interest of 10 percent on your money. The
inflation rate was 5 percent over the same period. The exact actual growth rate of your
purchasing power was
A. 15.5%.
B. 10.0%.
C. 5.0%.
D. 4.8%.
E. 15.0%.
r = (1 + R)/(1 + I) − 1; 1.10%/1.05% − 1 = 4.8%.
AACSB: Analytic
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Difficulty: Intermediate
Topic: Rates of Return

A. 15.5%.
B. 10.0%.
C. 3.8%.
D. 4.8%.
E. 15.0%.
r = (1 + R)/(1 + I) − 1 ; 1.08%/1.04% − 1 = 3.8%.
AACSB: Analytic
Bloom's: Apply

5-1
3. A year ago, you invested $1,000 in a savings account that pays an annual interest rate of
7%. What is your approximate annual real rate of return if the rate of inflation was 3% over
the year?
A. 4%.
B. 10%.
C. 7%.
D. 3%.
E. 6%.
7% − 3% = 4%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

5%. What is your approximate annual real rate of return if the rate of inflation was 3.5% over
the year?
A. 1.5%.
B. 10%.
C. 7%.
D. 3%.
E. 1%.
5% − 3.5% = 1.5%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

5-2
5. If the annual real rate of interest is 5% and the expected inflation rate is 4%, the nominal
rate of interest would be approximately
A. 1%.
B. 9%.
C. 20%.
D. 15%.
E. 7%.
5% + 4% = 9%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

6. If the annual real rate of interest is 2.5% and the expected inflation rate is 3.7%, the
nominal rate of interest would be approximately
A. 3.7%.
B. 6.2%.
C. 2.5%.
D. -1.2%.
E. 4.3%.
2.5% + 3.7% = 6.2%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

5-3
7. You purchased a share of stock for $20. One year later you received $1 as a dividend and
sold the share for $29. What was your holding-period return?
A. 45%
B. 50%
C. 5%
D. 40%
E. 32%
($1 + $29 − $20)/$20 = 0.5000, or 50%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

8. You purchased a share of stock for $30. One year later you received $1.50 as a dividend
and sold the share for $32.25. What was your holding-period return?
A. 12.5%
B. 12.0%
C. 13.6%
D. 11.8%
E. 14.1%
($1.5 + $32.25 − $30)/$30 = 0.125, or 12.5%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

5-4
9. Which of the following determine(s) the level of real interest rates?

I) The supply of savings by households and business firms
II) The demand for investment funds
III) The government's net supply and/or demand for funds
A. I only
B. II only
C. I and II only
D. I, II, and III
E. III only
The value of savings by households is the major supply of funds; the demand for investment
funds is a portion of the total demand for funds; the government's position can be one of
either net supplier, or net demander of funds. The above factors constitute the total supply and
demand for funds, which determine real interest rates.
AACSB: Analytic
Bloom's: Remember
Topic: Interest Rate Determinants

10. Which of the following statement(s) is (are) true?

I) The real rate of interest is determined by the supply and demand for funds.
II) The real rate of interest is determined by the expected rate of inflation.
III) The real rate of interest can be affected by actions of the Fed.
IV) The real rate of interest is equal to the nominal interest rate plus the expected rate of
inflation.
A. I and II only.
B. I and III only.
C. III and IV only.
D. II and III only.
E. I, II, III, and IV only.
The expected rate of inflation is a determinant of nominal, not real, interest rates. Real rates
are determined by the supply and demand for funds, which can be affected by the Fed.
AACSB: Analytic
Bloom's: Understand

5-5
11. Which of the following statements is true

A. Inflation has no effect on the nominal rate of interest.
B. The realized nominal rate of interest is always greater than the real rate of interest.
C. Certificates of deposit offer a guaranteed real rate of interest.
D. Certificates of deposit offer a guaranteed nominal rate of interest.
E. Inflation has no effect on the nominal rate of interest, the realized nominal rate of interest is
always greater than the real rate of interest, and certificates of deposit offer a guaranteed real
rate of interest
Expected inflation rates are a determinant of nominal interest rates. The realized nominal rate
of interest would be negative if the difference between actual and anticipated inflation rates
exceeded the real rate. The realized nominal rate of interest would be less than the real rate if
the unexpected inflation were greater than the real rate of interest. Certificates of deposit
contain a real rate based on an estimate of inflation that is not guaranteed.
AACSB: Analytic
Bloom's: Understand

12. Other things equal, an increase in the government budget deficit

A. drives the interest rate down.
B. drives the interest rate up.
C. might not have any effect on interest rates.
D. always increases business prospects.
E. never increases business prospects.
An increase in the government budget deficit, other things equal, causes the government to
increase its borrowing, which increases the demand for funds and drives interest rates up.
AACSB: Analytic
Bloom's: Understand

5-6
13. Ceteris paribus, a decrease in the demand for loanable funds

A. drives the interest rate down.
B. drives the interest rate up.
C. might not have any effect on interest rates.
D. results from an increase in business prospects and a decrease in the level of savings.
E. results from an increase in business prospects and a increase in the level of savings.
A decrease in demand, ceteris paribus, always drives interest rates down. An increase in
business prospects would increase the demand for funds. The savings level affects the supply
of, not the demand for, funds.
AACSB: Analytic
Bloom's: Understand

14. The holding-period return (HPR) on a share of stock is equal to

A. the capital gain yield during the period, plus the inflation rate.
B. the capital gain yield during the period, plus the dividend yield.
C. the current yield, plus the dividend yield.
D. the dividend yield, plus the risk premium.
E. the change in stock price.
The HPR of any investment is the sum of the capital gain and the cash flow over the period,
which for common stock is B.
AACSB: Analytic
Bloom's: Understand
Topic: Risk

5-7
15. Historical records regarding return on stocks, Treasury bonds, and Treasury bills between
1926 and 2009 show that
A. stocks offered investors greater rates of return than bonds and bills.
B. stock returns were less volatile than those of bonds and bills.
C. bonds offered investors greater rates of return than stocks and bills.
D. bills outperformed stocks and bonds.
E. treasury bills always offered a rate of return greater than inflation.
The historical data show that, as expected, stocks offer a greater return and greater volatility
than the other investment alternatives. Inflation sometimes exceeded the T-bill return.
AACSB: Analytic
Bloom's: Remember

16. If the interest rate paid by borrowers and the interest rate received by savers accurately
reflect the realized rate of inflation:
A. borrowers gain and savers lose.
B. savers gain and borrowers lose.
C. both borrowers and savers lose.
D. neither borrowers nor savers gain or lose.
E. both borrowers and savers gain.
If the described interest rate accurately reflects the rate of inflation, both borrowers and
lenders are paying and receiving, respectively, the real rate of interest; thus, neither group
gains.
AACSB: Analytic
Bloom's: Understand

You have been given this probability distribution for the holding-period return for KMP
stock:

5-8
17. What is the expected holding-period return for KMP stock?

A. 10.40%
B. 9.32%
C. 11.63%
D. 11.54%
E. 10.88%
HPR = .30 (18%) + .50 (12%) + .20 (−5%) = 10.4%
AACSB: Analytic
Bloom's: Apply
Topic: Risk

18. What is the expected standard deviation for KMP stock?

A. 6.91%
B. 8.13%
C. 7.79%
D. 7.25%
E. 8.85%
s = [.30 (18 − 10.4)2 + .50 (12 − 10.4)2 + .20 (−5 − 10.4)2]1/2 = 8.13%
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Return Analysis

19. What is the expected variance for KMP stock?

A. 66.04%
B. 69.96%
C. 77.04%
D. 63.72%
E. 78.45%
variance = [.30 (18 − 10.4)2 + .50 (12 − 10.4)2 + .20 (−5 − 10.4)2] = 66.04%
AACSB: Analytic
Bloom's: Apply

5-9
20. If the nominal return is constant, the after-tax real rate of return
A. declines as the inflation rate increases.
B. increases as the inflation rate increases.
C. declines as the inflation rate declines.
D. increases as the inflation rate decreases.
E. declines as the inflation rate increases and increases as the inflation rate decreases.
Inflation rates have an inverse effect on after-tax real rates of return.
AACSB: Analytic
Bloom's: Understand
Topic: Taxes and Interest

21. The risk premium for common stocks

A. cannot be zero, for investors would be unwilling to invest in common stocks.
B. must always be positive, in theory.
C. is negative, as common stocks are risky.
D. cannot be zero, for investors would be unwilling to invest in common stocks and must
always be positive, in theory.
E. cannot be zero, for investors would be unwilling to invest in common stocks and is
negative, as common stocks are risky.
If the risk premium for common stocks were zero or negative, investors would be unwilling to
accept the lower returns for the increased risk.
AACSB: Analytic
Bloom's: Understand
Topic: Risk

5-10
22. If a portfolio had a return of 15%, the risk free asset return was 3%, and the standard
deviation of the portfolio's excess returns was 34%, the risk premium would be _____.
A. 31%
B. 18%
C. 49%
D. 12%
E. 29%
15 − 3 = 12%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

23. You purchase a share of Boeing stock for $90. One year later, after receiving a dividend
of $3, you sell the stock for $92. What was your holding-period return?
A. 4.44%
B. 2.22%
C. 3.33%
D. 5.56%
E. 5.91%
HPR = (92 − 90 + 3)/90 = 5.56%
AACSB: Analytic
Bloom's: Apply
Topic: Risk

5-11
24. Toyota stock has the following probability distribution of expected prices one year from
now:

If you buy Toyota today for $55 and it will pay a dividend during the year of $4 per share,
what is your expected holding-period return on Toyota?
A. 17.72%
B. 18.89%
C. 17.91%
D. 18.18%
E. 16.83%
E(P1) = .25 (54/55 − 1) + .40 (64/55 − 1) + .35 (74/55 − 1) = 18.18%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

25. Which of the following factors would not be expected to affect the nominal interest rate?
A. The supply of loanable funds
B. The demand for loanable funds
C. The coupon rate on previously issued government bonds
D. The expected rate of inflation
E. Government spending and borrowing
The nominal interest rate is affected by supply, demand, government actions and inflation.
Coupon rates on previously issued government bonds reflect historical interest rates but
should not affect the current level of interest rates.
AACSB: Analytic
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Difficulty: Basic

5-12
A. 14%
B. 6%
C. 35%
D. 21%
E. 29%
10 − 4 = 6%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

27. In words, the real rate of interest is approximately equal to

A. the nominal rate minus the inflation rate.
B. the inflation rate minus the nominal rate.
C. the nominal rate times the inflation rate.
D. the inflation rate divided by the nominal rate.
E. the nominal rate plus the inflation rate.
The actual relationship is (1 + real rate) = (1 + nominal rate)/(1 + inflation rate). This can be
approximated by the equation: real rate = nominal rate - inflation rate.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic

5-13
28. If the Federal Reserve lowers the discount rate, ceteris paribus, the equilibrium levels of
funds lent will __________ and the equilibrium level of real interest rates will ___________.
A. increase; increase
B. increase; decrease
C. decrease; increase
D. decrease; decrease
E. reverse direction from their previous trends
A lower discount rate would encourage banks to make more loans, which would increase the
money supply. The supply curve would shift to the right and the equilibrium level of funds
would increase while the equilibrium interest rate would fall.
AACSB: Analytic
Bloom's: Apply

29. What has been the relationship between T-Bill rates and inflation rates since the 1980s?
A. The T-Bill rate was sometimes higher than and sometimes lower than the inflation rate.
B. The T-Bill rate has equaled the inflation rate plus a constant percentage.
C. The inflation rate has equaled the T-Bill rate plus a constant percentage.
D. The T-Bill rate has been higher than the inflation rate almost the entire period.
E. The T-Bill rate has been lower than the inflation rate almost the entire period.
The T-Bill rate was higher than the inflation rate for over two decades.
AACSB: Analytic
Bloom's: Remember

5-14
30. "Bracket Creep" happens when

A. tax liabilities are based on real income and there is a negative inflation rate.
B. tax liabilities are based on real income and there is a positive inflation rate.
C. tax liabilities are based on nominal income and there is a negative inflation rate.
D. tax liabilities are based on nominal income and there is a positive inflation rate.
E. too many peculiar people make their way into the highest tax bracket.
A positive inflation rate typically leads to higher nominal income. Higher nominal income
means people will have higher tax liabilities and in some cases will put them in higher tax
brackets. This can happen even when real income has declined.
AACSB: Analytic
Bloom's: Remember
Topic: Taxes and Interest

31. The holding-period return (HPR) for a stock is equal to

A. the real yield minus the inflation rate.
B. the nominal yield minus the real yield.
C. the capital gains yield minus the tax rate.
D. the capital gains yield minus the dividend yield.
E. the dividend yield plus the capital gains yield.
HPR consists of an income component and a price change component. The income
component on a stock is the dividend yield. The price change component is the capital gains
yield.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Risk

5-15
32. The historical arithmetic rate of return on U.S. small stocks over the 1926-2009 period has
been _______. The standard deviation of small stocks' returns has been ________ than the
standard deviation of large stocks' returns.
A. 12.43%, lower
B. 13.11%, lower
C. 16.24%, higher
D. 17.43%, higher
E. 21.53%, higher
See Table 5.3.
AACSB: Analytic
Bloom's: Remember

You have been given this probability distribution for the holding-period return for Cheese,
Inc stock:

33. Assuming that the expected return on Cheese's stock is 14.35%, what is the standard
deviation of these returns?
A. 4.72%
B. 6.30%
C. 4.38%
D. 5.74%
E. 6.67%
Variance = .20*(24 − 14.35)2 + .45*(15 − 14.35)2 + .35*(8 − 14.35)2 = 32.9275. Standard

deviation = 32.92751/2 = 5.74.
AACSB: Analytic
Bloom's: Apply

5-16
34. An investor purchased a bond 45 days ago for $985. He received $15 in interest and sold
the bond for $980. What is the holding-period return on his investment?
A. 1.52%
B. 0.50%
C. 1.92%
D. 0.01%
E. 1.02%
HPR = ($15 + 980 − 985)/$985 = .010152284 = approximately 1.02%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic
Topic: Risk

35. An investor purchased a bond 63 days ago for $980. He received $17 in interest and sold
the bond for $987. What is the holding-period return on his investment?
A. 1.52%
B. 2.45%
C. 1.92%
D. 2.68%
E. 3.28%
HPR = ($17 + 987 − 980)/$980 = .0244898 = approximately 2.45%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic
Topic: Risk

5-17
inflation rate was 3.5 percent over the same period. The exact actual growth rate of your
A. 15.55%.
B. 4.35%.
C. 5.02%.
D. 4.81%.
E. 15.04%.
r = (1 + R)/(1 + I) − 1; 1.08/1.035 − 1 = 4.35%.
AACSB: Analytic
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A. 11.76%.
B. 16.00%.
C. 15.02%.
D. 14.32%.
E. 10.53%.
r = (1 + R)/(1 + I) − 1; 1.14/1.02 − 1 = 11.76%.
AACSB: Analytic
Bloom's: Apply

5-18
38. Over the past year you earned a nominal rate of interest of 12.5 percent on your money.
The inflation rate was 2.6 percent over the same period. The exact actual growth rate of your
A. 9.15%.
B. 9.90%.
C. 9.65%.
D. 10.52%.
E. 4.35%.
r = (1 + R)/(1 + I) − 1; 1.125/1.026 − 1 = 9.65%.
AACSB: Analytic
Bloom's: Apply

the year?
A. 4%.
B. 2%.
C. 6%.
D. 3%.
E. 1%.
4% − 2% = 2%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

5-19
the year?
A. 1%.
B. -1%.
C. 7%.
D. 3%.
E. -2%.
3% − 4% = −1%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

2.5%. What is your approximate annual real rate of return if the rate of inflation was 1.6%
over the year?
A. 4.1%.
B. 2.5%.
C. 2.9%.
D. 1.6%.
E. 0.9%.
2.5% − 1.6% = 0.9%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

5-20
2.5%. What is your approximate annual real rate of return if the rate of inflation was 3.4%
over the year?
A. 0.9%.
B. -0.9%.
C. 5.9%.
D. 3.4%.
E. -1.2%.
2.5% − 3.4% = −0.9%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

43. A year ago, you invested $12,000 in an investment that produced a return of 16%. What is
your approximate annual real rate of return if the rate of inflation was 2% over the year?
A. 18%.
B. 2%.
C. 16%.
D. 15%.
E. 14%.
16% − 2% = 14%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

5-21
A. 3.5%.
B. 2.5%.
C. 1%.
D. 6.8%.
E. 6%.
3.5% + 2.5% = 6%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

A. 4.9%.
B. 0.9%.
C. -0.9%.
D. 7%.
E. 5.9%.
2.5% + 3.4% = 5.9%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

5-22
46. If the annual real rate of interest is 4% and the expected inflation rate is 3%, the nominal
rate of interest would be approximately
A. 4%.
B. 3%.
C. 1%.
D. 5%.
E. 7%.
4% + 3% = 7%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

and sold the share for $12.92. What was your holding-period return?
A. 9.75%
B. 10.65%
C. 11.75%
D. 11.25%
E. 8.46%
($0.25 + $12.92 − $12)/$12 = 0.0975, or 9.75%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

5-23
and sold the share for $136. What was your holding-period return?
A. 15.67%
B. 22.12%
C. 18.85%
D. 13.24%
E. 14.85%
($1.82 + $136 − $120)/$120 = 0.1485, or 14.85%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

and sold the share for $63. What was your holding-period return?
A. 0.57%
B. -0.2550%
C. -0.89%
D. 1.63%
E. -0.46%
($2.37 + $63 − $65)/$65 = 0.00569, or 0.57%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

You have been given this probability distribution for the holding-period return for a stock:

5-24
50. What is the expected holding-period return for the stock?

A. 11.67%
B. 8.33%
C. 9.56%
D. 12.4%
E. 10.4%
HPR = .40 (22%) + .35 (11%) + .25 (−9%) = 10.4%
AACSB: Analytic
Bloom's: Apply
Topic: Risk

51. What is the expected standard deviation for the stock?

A. 2.07%
B. 9.96%
C. 7.04%
D. 1.44%
E. 12.17%
s = [.40 (22 − 10.4)2 + .35 (11 − 10.4)2 + .25 (−9 − 10.4)2]1/2 = 12.167%
AACSB: Analytic
Bloom's: Apply

52. What is the expected variance for the stock?

A. 142.07%
B. 189.96%
C. 177.04%
D. 128.17%
E. 148.04%
Variance = [.40 (22 − 10.4)2 + .35 (11 − 10.4)2 + .25 (−9 − 10.4)2] = 148.04%
AACSB: Analytic
Bloom's: Apply

5-25
53. Which of the following measures of risk best highlights the potential loss from extreme
negative returns?
A. Standard deviation
B. Variance
C. Upper partial standard deviation
D. Value at Risk (VaR)
E. Sharpe measure
Only VaR measures potential loss from extreme negative returns.
AACSB: Analytic
Bloom's: Understand
Topic: Risk

54. Over the past year you earned a nominal rate of interest of 3.6 percent on your money.
The inflation rate was 3.1 percent over the same period. The exact actual growth rate of your
A. 3.6%.
B. 3.1%.
C. 0.48%.
D. 6.7%.
E. -0.63%
r = (1 + R)/(1 + I) − 1; 1.036/1.031% − 1 = 0.484%.
AACSB: Analytic
Bloom's: Apply

5-26
4.3%. What is your approximate annual real rate of return if the rate of inflation was 3% over
the year?
A. 4.3%.
B. -1.3%.
C. 7.3%.
D. 3%.
E. 1.3%.
4.3% − 3% = 1.3%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

A. 0%.
B. 3.5%.
C. 12.25%.
D. 7%.
E. 2.6%.
3.5% + 3.5% = 7%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Basic

5-27
57. You purchased a share of CSCO stock for $20. One year later you received $2 as a
dividend and sold the share for $31. What was your holding-period return?
A. 45%
B. 50%
C. 60%
D. 40%
E. 65%
($2 + $31 − $20)/$20 = 0.65, or 65%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

You have been given this probability distribution for the holding-period return for GM stock:

58. What is the expected holding-period return for GM stock?

A. 10.4%
B. 11.4%
C. 12.4%
D. 13.4%
E. 14.4%
HPR = .40 (30%) + .40 (11%) + .20 (−10%) = 14.4%
AACSB: Analytic
Bloom's: Apply
Topic: Risk

5-28
59. What is the expected standard deviation for GM stock?

A. 16.91%
B. 16.13%
C. 13.79%
D. 15.25%
E. 14.87%
s = [.40 (30 − 14.4)2 + .40 (11 − 14.4)2 + .20 (−10 − 14.4)2]1/2 = 14.87%
AACSB: Analytic
Bloom's: Apply

60. What is the expected variance for GM stock?

A. 200.00%
B. 221.04%
C. 246.37%
D. 14.87%
E. 16.13%
variance = [.40 (30 − 14.4)2 + .40 (11 − 14.4)2 + .20 (−10 − 14.4)2] = 221.04%
AACSB: Analytic
Bloom's: Apply

5-29
61. You purchase a share of CAT stock for $90. One year later, after receiving a dividend of
$4, you sell the stock for $97. What was your holding-period return?
A. 14.44%
B. 12.22%
C. 13.33%
D. 5.56%
E. 15.21%
HPR = ([97 − 90] + 4)/90 = 12.22%
AACSB: Analytic
Bloom's: Apply
Topic: Risk

62. When comparing investments with different horizons the ____________ provides the
more accurate comparison.
A. arithmetic average
B. effective annual rate
C. average annual return
D. historical annual average
E. geometric return
The effective annual rate provides the more accurate comparison of investments with different
horizons because it expresses the returns in a common period.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic

5-30
63. Annual Percentage Rates (APRs) are computed using

A. simple interest.
B. compound interest.
C. either simple interest or compound interest can be used.
D. best estimates of expected real costs.
E. real interest.
APRs use simple interest.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic

64. An investment provides a 2% return semi-annually, its effective annual rate is
A. 2%.
B. 4%.
C. 4.02%.
D. 4.04%.
E. 4.53%.
(1.02)2 − 1 = 4.04%
AACSB: Analytic
Bloom's: Apply

65. An investment provides a 1.25% return quarterly, its effective annual rate is
A. 5.23%.
B. 5.09%.
C. 4.02%.
D. 4.04%.
E. 2.61%.
(1.0125)4 − 1 = 5.09%
AACSB: Analytic
Bloom's: Apply

5-31
66. An investment provides a 0.78% return monthly, its effective annual rate is
A. 9.36%.
B. 9.63%.
C. 10.02%.
D. 9.77%.
E. 10.38%.
(1.0078)12 − 1 = 9.77%
AACSB: Analytic
Bloom's: Apply

67. An investment provides a 3% return semi-annually, its effective annual rate is
A. 3%.
B. 6%.
C. 6.06%.
D. 6.09%.
E. 5.91%.
(1.03)2 − 1 = 6.09%
AACSB: Analytic
Bloom's: Apply

68. An investment provides a 2.1% return quarterly, its effective annual rate is
A. 2.1%.
B. 8.4%.
C. 8.56%.
D. 8.67%.
E. 9.34%.
(1.021)4 − 1 = 8.67%
AACSB: Analytic
Bloom's: Apply

5-32
69. Skewness is a measure of ____________.

A. how fat the tails of a distribution are
B. the downside risk of a distribution
C. the normality of a distribution
D. the dividend yield of the distribution
E. the average of the distribution
Skewness is a measure of the normality of a distribution.
AACSB: Analytic
Bloom's: Remember
Topic: Normal Distribution

70. Kurtosis is a measure of ____________.

A. how fat the tails of a distribution are
B. the downside risk of a distribution
C. the normality of a distribution
D. the dividend yield of the distribution
E. how fat the tails of a distribution are and the normality of a distribution
Kurtosis is a measure of the normality of a distribution that specifically measures how fat the
tails are.
AACSB: Analytic
Bloom's: Remember

5-33
71. When a distribution is positively skewed, ____________.

A. standard deviation overestimates risk
B. standard deviation correctly estimates risk
C. standard deviation underestimates risk
D. the tails are fatter than in a normal distribution
E. the tails are skinnier than in a normal distribution
When a distribution is positively skewed standard deviation overestimates risk.
AACSB: Analytic
Bloom's: Remember

72. When a distribution is negatively skewed, ____________.

A. standard deviation overestimates risk
B. standard deviation correctly estimates risk
C. standard deviation underestimates risk
D. the tails are fatter than in a normal distribution
E. the tails are skinnier than in a normal distribution
When a distribution is negatively skewed standard deviation underestimates risk.
AACSB: Analytic
Bloom's: Remember

73. If a distribution has "fat tails" it exhibits

A. positive skewness
B. negative skewness
C. a kurtosis of zero
D. kurtosis
E. positive skewness and kurtosis
Kurtosis is a measure of the tails of a distribution or "fat tails."
AACSB: Analytic
Bloom's: Remember

5-34
deviation of the portfolio's excess returns was 20%, the Sharpe measure would be _____.
A. 0.08
B. 0.03
C. 0.20
D. 0.11
E. 0.25
(8 − 3)/20 = 0.25
AACSB: Analytic
Bloom's: Apply

A. 0.12
B. 0.04
C. 0.32
D. 0.16
E. 0.25
(12 − 4)/25 = 0.32
AACSB: Analytic
Bloom's: Apply

5-35
A. 0.20
B. 0.35
C. 0.45
D. 0.33
E. 0.25
(15 − 5)/30 = 0.33
AACSB: Analytic
Bloom's: Apply

A. 8%
B. 16%
C. 37%
D. 21%
E. 29%
12 − 4 = 8%.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

5-36
78. ________ is/are a risk measure that indicate(s) vulnerability to extreme negative returns.
A. Value at risk
B. Lower partial standard deviation
C. Standard deviation
D. Variance
E. Value at risk and lower partial standard deviation
Value at risk and lower partial standard deviation are risk measures that indicate vulnerability
to extreme negative returns.
AACSB: Analytic
Bloom's: Understand
Topic: Risk

79. ________ is/are a risk measure(s) that indicates vulnerability to extreme negative returns.
A. Value at risk
B. Lower partial standard deviation
C. Expected shortfall
D. Variance
E. Value at risk, lower partial standard deviation, and expected shortfall
All of the above are risk measures that indicate vulnerability to extreme negative returns.
AACSB: Analytic
Bloom's: Understand
Topic: Risk

5-37
80. The most common measure of loss associated with extremely negative returns is
________.
A. lower partial standard deviation
B. value at risk
C. expected shortfall
D. standard deviation
E. Variance
The most common measure of loss associated with extremely negative returns is value at risk.
AACSB: Analytic
Bloom's: Understand
Topic: Risk

81. Practitioners often use a ________ % VaR, meaning that ________ % of returns will
exceed the VaR, and ________ % will be worse.
A. 25, 75, 25
B. 75, 25, 75
C. 5, 95, 5
D. 95, 5, 95
E. 80, 80, 20
Practitioners often use a 5% VaR, meaning that 95% of returns will exceed the VaR, and 5%
will be worse.
AACSB: Analytic
Bloom's: Apply
Topic: Risk

5-38
82. When assessing tail risk by looking at the 5% worst-case scenario, the VaR is the
________.
A. most realistic as it is the most complete measure of risk
B. most pessimistic as it is the most complete measure of risk
C. most optimistic as it is the most complete measure of risk
D. most optimistic as it takes the highest return (smallest loss) of all the cases
E. most unrealistic as it is the least complete measure of risk
When assessing tail risk by looking at the 5% worst-case scenario, the VaR is the most
optimistic as it takes the highest return (smallest loss) of all the cases.
AACSB: Analytic
Bloom's: Understand

83. When assessing tail risk by looking at the 5% worst-case scenario, the most realistic view
of downside exposure would be ________.
A. expected shortfall
B. value at risk
C. conditional tail expectation
D. expected shortfall and value at risk
E. expected shortfall and conditional tail expectation
When assessing tail risk by looking at the 5% worst-case scenario, the most realistic view of
downside exposure would be expected shortfall (or conditional tail expectation).
AACSB: Analytic
Bloom's: Understand

5-39
Short Answer Questions

84. Discuss the relationships between interest rates (both real and nominal), expected inflation
rates, and tax rates on investment returns.
The nominal interest rate is the quoted interest rate; however this rate is approximately equal
to the real rate of interest plus the expected rate of inflation. Thus, an investor is expecting to
earn the real rate in terms of the increased purchasing power resulting from the investment. In
addition, the investor should consider the after-tax returns on the investment. The higher the
inflation rate, the lower the real after-tax rate of return. Investors suffer an inflation penalty
equal to the tax rate times the inflation rate.
Feedback: The rationale for this question is to ascertain that the student understands the
relationships among these basic determinants of the after-tax real rate of return.
AACSB: Reflective Thinking

Bloom's: Evaluate

85. Discuss why common stocks must earn a risk premium.
Most investors are risk averse; that is, in order to accept the risk involved in investing in
common stocks, the investors expect a return from the stocks over and above the return the
investors could earn from a risk-free investment, such as U.S. Treasury issues. This excess
return (the return in excess of the risk-free rate) is the risk premium required by the investors
to invest in common stocks.
Feedback: The purpose of this question is to ascertain that the students understand the basic
risk-return relationship, as the relationship applies to investing in common stocks vs. a risk-
free asset (i.e., why would investors be willing to assume the risk of common stock as
investment vehicles?).

Bloom's: Evaluate
Difficulty: Basic
Topic: Risk

5-40
86. Discuss the historical distributions of each of the following in terms of their average
return and the dispersion of their returns: U.S. small company stocks, U.S. large company
stocks, and U.S. long-term government bonds. Would any of these investments cause a loss in
purchasing power during a 1926-2009 holding period?
The data given in Table 5.3

Whether the averages are measured on a geometric basis or an arithmetic basis, the ranking is
always the same, with small company average>large company average>government bond
average. With regard to risk, the relationships among the standard deviations are small
company>large company>government bonds. These ranks indicate that the ex-post data
confirm what would be expected - higher returns are earned to compensate for the increased
risk. None of these investments would have caused a loss in purchasing power during the
1926-2009 period, because all had average returns higher than the average inflation rate.
Feedback: The goal of this question is to see if students have a general idea of the historical
relationships among the returns and risk levels of various categories of investments relative to
each other and to the level of inflation.

Bloom's: Apply

5-41
87. Discuss some reasons why an investor with a long time horizon might choose to invest in
common stocks, even though they have historically been riskier than government bonds or T-
bills.
Common stocks can be expected to provide for the best growth in purchasing power based on
historical data. An investor with a long time horizon can tolerate fluctuations in stock returns
because of the long-term upward trend in stock returns. How much common stock an investor
is willing to hold and what types of stocks he chooses for his portfolio will depend on his
level of risk aversion.
Feedback: The goal of this question is to see if students have a general idea of the historical
relationships among the returns and risk levels and why investors may choose stocks for long-
term investments.

Bloom's: Evaluate
Difficulty: Basic
Topic: Risk

5-42

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Chapter 05 - Introduction to Risk, Return, and the Historical Record

Multiple Choice Questions

r = (1 + R)/(1 + I) − 1; 1.10%/1.05% − 1 = 4.8%.

r = (1 + R)/(1 + I) − 1 ; 1.08%/1.04% − 1 = 3.8%.

2.5% + 3.7% = 6.2%.

($1 + $29 − $20)/$20 = 0.5000, or 50%.

($1.5 + $32.25 − $30)/$30 = 0.125, or 12.5%.

9. Which of the following determine(s) the level of real interest rates?

10. Which of the following statement(s) is (are) true?

11. Which of the following statements is true

12. Other things equal, an increase in the government budget deficit

13. Ceteris paribus, a decrease in the demand for loanable funds

14. The holding-period return (HPR) on a share of stock is equal to

17. What is the expected holding-period return for KMP stock?

HPR = .30 (18%) + .50 (12%) + .20 (−5%) = 10.4%

18. What is the expected standard deviation for KMP stock?

19. What is the expected variance for KMP stock?

Inflation rates have an inverse effect on after-tax real rates of return.

21. The risk premium for common stocks

HPR = (92 − 90 + 3)/90 = 5.56%

E(P1) = .25 (54/55 − 1) + .40 (64/55 − 1) + .35 (74/55 − 1) = 18.18%.

27. In words, the real rate of interest is approximately equal to

30. "Bracket Creep" happens when

31. The holding-period return (HPR) for a stock is equal to

See Table 5.3.

Variance = .20*(24 − 14.35)2 + .45*(15 − 14.35)2 + .35*(8 − 14.35)2 = 32.9275. Standard

HPR = ($15 + 980 − 985)/$985 = .010152284 = approximately 1.02%.

HPR = ($17 + 987 − 980)/$980 = .0244898 = approximately 2.45%.

r = (1 + R)/(1 + I) − 1; 1.08/1.035 − 1 = 4.35%.

r = (1 + R)/(1 + I) − 1; 1.14/1.02 − 1 = 11.76%.

r = (1 + R)/(1 + I) − 1; 1.125/1.026 − 1 = 9.65%.

2.5% − 1.6% = 0.9%.

2.5% − 3.4% = −0.9%.

3.5% + 2.5% = 6%.

2.5% + 3.4% = 5.9%.

($0.25 + $12.92 − $12)/$12 = 0.0975, or 9.75%.

($1.82 + $136 − $120)/$120 = 0.1485, or 14.85%.

($2.37 + $63 − $65)/$65 = 0.00569, or 0.57%.

50. What is the expected holding-period return for the stock?

HPR = .40 (22%) + .35 (11%) + .25 (−9%) = 10.4%

51. What is the expected standard deviation for the stock?

52. What is the expected variance for the stock?

Only VaR measures potential loss from extreme negative returns.

r = (1 + R)/(1 + I) − 1; 1.036/1.031% − 1 = 0.484%.

3.5% + 3.5% = 7%.

($2 + $31 − $20)/$20 = 0.65, or 65%.

58. What is the expected holding-period return for GM stock?

HPR = .40 (30%) + .40 (11%) + .20 (−10%) = 14.4%

59. What is the expected standard deviation for GM stock?

60. What is the expected variance for GM stock?

HPR = ([97 − 90] + 4)/90 = 12.22%

63. Annual Percentage Rates (APRs) are computed using

APRs use simple interest.

69. Skewness is a measure of ____________.

Skewness is a measure of the normality of a distribution.

70. Kurtosis is a measure of ____________.

71. When a distribution is positively skewed, ____________.

When a distribution is positively skewed standard deviation overestimates risk.

72. When a distribution is negatively skewed, ____________.

When a distribution is negatively skewed standard deviation underestimates risk.

73. If a distribution has "fat tails" it exhibits

Kurtosis is a measure of the tails of a distribution or "fat tails."

(12 − 4)/25 = 0.32

(15 − 5)/30 = 0.33

Variance = .20(24 − 14.35)2 + .45(15 − 14.35)2 + .35*(8 − 14.35)2 = 32.9275. Standard